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“Masterful Misdirection” " . . . the curious incident of the dog in the nighttime." "The dog did nothing in the nighttime." "That was the curious incident," Sherlock
Holmes As Alan Greenspan read his prepared remarks on monetary policy before the Senate today, a pair of thumbs could be seen twiddling behind him. Just so, since he had virtually nothing to say on the subject. Dedicating 25 paragraphs to the economy, Mr. Greenspan offered up a skimpy 2 paragraphs on monetary policy, telling us what we already knew: Fed policy shifted from fighting inflation to fomenting economic growth, prompting two 1/2% reductions in the fed funds target rate. Really? The curious thing about the Fed Chairman's testimony was the total lack of discussion of the primary lever of monetary policy: money supply. How can a presentation on monetary policy fail to mention the money supply, you ask? Easy. The Fed doesn't want to talk about it, since some very strange things have been happening with the money supply recently. In fact, the Fed has done everything it can in recent years to render money supply invisible. Today's performance revealed Greenspan's mastery of what magicians call "misdirection" (directing your attention toward the flower in the left hand so you don't see the right hand reaching for the gold coin in the pocket). After saying virtually nothing on monetary policy, the chairman deftly concluded his remarks by leading the Senators into the briar patch of fiscal policy where they remained contentedly for the Q&A session. This suited the chairman just fine, since any thoughtful discussion of money supply would surely raise uncomfortable questions. For example: - Why has growth of the M2 money supply skyrocketed to an inflationary 10% annual rate since the end of October? (Could it have anything to do with swoon in stock prices beginning in early October and the slowing growth of the economy in the fourth quarter?) - Why did the growth rate of M2 rise above the Fed's maximum target of 5% to an average around 8% between 1997 and 1999? (Could it have anything to do with the sagging economies of Asia and Russia or the slumping stock market in 1998?) - Does this extraordinary surge in new money have anything to do with the rise in inflation to 3.4% in 2000? The timing and magnitude of these spurts in monetary growth clearly reveal the Fed's initiatives to revive weak foreign economies, resuscitate a stalling U.S. economy and rescue a sagging U.S. stock market by supplying Americans with the wherewithal to buy foreign and domestic goods, services and U.S. stocks. In so doing the Fed has placed these objectives above its principal charter to control inflation. Not surprisingly, inflation has revived, rising above the threshold of acceptability around 3% to 3.4% at the end of 2000, even as the economy slowed. You can't print new money faster than the economy grows without creating inflation. More ominously, by injecting all this new money into the private economy, Greenspan has contributed to the destabilizing "imbalances" he so often complains about: excessive consumer and corporate debt, massive international trade deficits and overvalued U.S. stocks. These imbalances now add weight to the predominant "downside risks" Greenspan foresees. One of my subscribers recently asked a penetrating question: "If you disagree with Greenspan's course of action, what would you do instead to restore stable growth without inflation for our economy?" My reply seems pertinent to the present discussion: "Rather than pump up the money supply into inflationary territory every time a crisis looms, as Greenspan has done for the last three years, I would keep the money supply growing at about the same rate as the economy -- avoiding the inflationary consequences of too much money chasing too few goods, while providing the necessary solvent for economic growth -- and leave it to the free markets to do the job of regulating economic activity. Free markets regulate economic activity by rewarding profitable resource-allocation decisions and punishing unprofitable ones. Bull markets, strong currencies and growing economies are the rewards for profitable decisions, whereas bear markets, currency devaluations and recessions are punishment for unprofitable decisions. These punishments should be allowed to manifest themselves from time to time through the free marketplace, which is better able to discern profitable from unprofitable decisions than are politicians or central bankers. If we attempt to keep the party going endlessly, as Greenspan has done, we deprive the market of its ability to punish unprofitable decisions along the way. Consequently, these unprofitable decisions -- revealed in "imbalances" like too much debt, overvalued stock prices, endless trade mega-deficits -- build up in the economy until the punishment of the market will no longer be denied, and stock markets crash, currencies devalue and great depressions result. The net effect is to trade off a series of small adjustments along the way for one big adjustment later on. Unlike Greenspan, I favor the former over the latter." Assuming Mr. Greenspan's emphasis on a "stalling economy" presaged further interest rate reductions and a snap back in the economy, the stock market surged during his testimony. However, the bond market wasn't buying it. Rallying only briefly, bond prices promptly weakened on the apparent assumption that these rescue operations would prompt the Fed to continue flooding the banking system with new money, creating more inflation that will push interest rates higher, eventually defeating the attempted rescues. Consequently stocks slumped late in the day, as investors, frightened by rising interest rates, focused on the stalling economy's depressing effect on corporate profits. The Dow eased 0.4% while the NASDAQ dropped 2.5% by the close today. In sorting out the investment implications of Mr. Greenspan's monetary policy, I side with the bond market, fearing the inflationary implications of recent surges in the money supply: higher interest rates inhibiting future economic growth, lower corporate profits and falling stock prices. Moreover, a visible resurgence of inflation would force the Fed to chop the unsustainable recent surge in monetary growth, undermining economic growth and stock prices in a classic resolution of the current economic cycle. The most recent M2 money supply statistics reveal a downtick in the last couple of weeks that could presage such a move even before inflation is generally seen as a problem. Consequently, I reaffirm my longstanding recommendations to avoid stocks and long-term bonds in favor of cash equivalents in the interest of preserving capital at a time when, in Chairman Greenspan's words, "downside risks predominate." |
